A renowned economist explains how Taylor’s rule goes along with inflation targeting, why governmental support of certain areas of economy needs a discriminative approach, and what Ukraine should expect after a comeback to the external borrowings market

John Taylor is a world-famous economist. In 1992, he developed a rule for the sphere of monetary policy (first for the USA, and later – for many developed countries) – the domain where, it seemed, there could be no rules.

Taylor’s rule is a proposed guideline of the responsiveness of the nominal interest rate of the Federal Reserve to changes in inflation and economic cycles. Today, the Federal Reserve is not following the Taylor’s rule directly, although when the actions of the central bank matched with the Taylor’s rule the US economy felt better than in those times when the Federal Reserve departed from it. In late May, Taylor visited Ukraine to take part in the conference “The Role of Central Bank in the Economic Development” co-organized by the National Bank of Ukraine and the National Bank of Poland. VoxUkraine (in cooperation with the Economic Strategy Center and “Ekonomichna Pravda” website) talked with Taylor on the most topical issues of global monetary policy and the actions of the Ukrainian central bank.

– You are famous for your Taylor Rule. Our readers are not very familiar with it. So, could you please explain what this rule is about, and why it is important for monetary policy?

T: So, the rule is a way to determine what the interest rate should be for a central bank. It considers two main factors. The first is inflation, and the second is GDP, or the state of the economy. It says that when inflation is picking up, the interest rate should be higher than normal, and when inflation is below, going down below the target, the interest rate should be lower than normal.

It also is the same kind of story for GDP. If the economy is booming, GDP is higher than normal, then the interest rate should be higher and vice versa. When the economy is weak, inflation is below its normal potential, which would mean interest rate should be reduced.

The addition to all that is it tells you how much the interest rate should change. How much higher it should be, how much lower it should be. And that turns out to be very simple guideline for central banks. It has worked pretty well, when central banks have followed that.

So that’s what it is.

So, you have a historical basis for it. And I guess the other thing that is important is a strategy or a rule, or something that gives some understanding of what monetary policy is all about. It’s not just ad hoc, it’s not just politicized, it’s systematic. And so that is another advantage to it.

– In Ukraine, the central bank has recently shifted to inflation targeting. Can you also explain the connection between the inflation targeting and the Taylor rule? Is it applicable for small open economies?

T: Yeah, so inflation targeting basically means you have a target for inflation. Тhe national bank of Ukraine can say, it’s eight, then it’s gonna be six and then it’s gonna be five. In the US, it is just now two.

And so that’s the target. Inflation targeting means you try to get inflation to that target by using monetary policy. The Taylor Rule is completely consistent with that.

So, in the original Taylor Rule, the inflation target is 2%. Now many central banks have this 2% for a goal.

If the National bank of Ukraine as well goes down the road, so, the rule is just a way to achieve the target.

– There is an opinion that in developed economies, inflation targets are set too low, and they should be increased. What do you think about that?

– Well, there’s a big discussion and question about what the best inflation target is. I think it is important to have an inflation target that is appropriate for the country. So, it’s not unusual to have a higher than two percent inflation target for countries that are developing. I hope, eventually economics will develop. And then you can think about a lower rate.

I think there’s some value to having the same inflation target for all countries. Of course, not right now. It provides some international stability. Exchange rates will not change as much. Monetary policies are similar in each country. So, eventually the same inflation target I think is a good idea. But, in the meantime, we are getting to that slowly.

The US didn’t have any inflation target for a long time. And, now it has one, but it didn’t have one for a while. In particular, it had a high inflation rate, and it gradually came down until it made sense to have an inflation target.

– Who has to set the inflation target? Who exactly has to do it, and what are the basics for choosing the particular target?

– Well, that’s a good question. I can answer that in the context of the Taylor Rule, because it shows 2%. Inflation is measured with some error. Usually, you figure it is an upward bias in the measure because people substitute out of goods whose prices are higher. So, maybe 2% actually means 1%. So, it’s a measurement bias, and you correct for that.

The other thing is that one was always concerned about the interest rate not being able to go below zero. So, if you have a somewhat higher inflation target like two, then there is more room for the interest rate to move up and down.

I think that reflects a lot of thinking in central banks, who have thought about how they don’t want it to be too high, they don’t want it to be too low. And that`s why two is a number they tend to follow, and that’s why two is very common.

– It’s interesting, we heard yesterday the opinion from several economists from central banks that two is too low, and that setting the inflation target too low is the very reason for negative exchange rates for example in Europe.

– I don’t think I really agree with it. I think that two has already worked fine. But, now there is discussion about that. And one reason is there’s a view out there that the normal interest rate is lower. So, for example, in the original Taylor Rule, the normal interest rate in real terms was 2%. With an inflation target of two that meant 4%. Two plus two is four. That meant the normal nominal interest rate was four.

So now, people are saying the interest rates have been lower than that. Four is too high, it should be three. For example, the Federal Open Market Committee that sets policy for the Fed had assumed four until about 2 or 3 years ago. Now they reduced to 3%.

So, once it is 3, then well maybe the two is too low and for the inflation target. Maybe you should get the 3%, so that would offset the interest rate and come to the same kind of conclusion. Eventually a three percent inflation target, one percent real, gives you four. So, that’s part of the reasoning. I don’t fully agree myself, but that’s why some people say it should be higher. It is important to mention that in developing countries, especially a country which has had a high inflation recently, and Ukraine among them, that getting to 5% is an accomplishment, important. Do that and then see what happens.

Q: This year we have inflation target 8%.

T: Yeah, so the target is 8%, then 6%, then 5%. So, that makes sense to me, doing it gradually. You don’t want to go too fast.

Q; Do you know some countries, some successful examples, where economic growth was achieved with the policy of the central bank without negative consequences for inflation and exchange rate?

T: So, the United States is a good example I believe. In the 1970s, goes back a long time, we had very high inflation, low growth, and high unemployment. Not a good mixture. Then, we changed our policy to have lower inflation, and so the Fed raised interest rates. The result was lower inflation. But, that lower inflation began in the early 80s, and after that unemployment came down and growth came up. So, that’s an example of what you’re talking about. The effort to get inflation down was good for growth because the high inflation rate is not good for growth. And that low inflation rate produced more growth which made people look at the 80s and 90s as a very successful period. Higher growth, lower unemployment. So, that’s one of the examples, but there’s others.

Q: This is the question referring to Ukrainian experience and the talks which are going on about the policy of Ukrainian central bank when the interest rates were pushed to 30% and some people argued that this damaged economic growth and even now the 13% rate damages economic growth. They argued that the policy of fighting inflation could be regarded as a tradeoff for economic growth supporting policies. What do you think about this?

T: That’s one of the reasons to try not have a high inflation rate in the first place. So, the cost that you’re talking about is the high inflation rate, and so 50% inflation is not good. 100% is even worse. But, 15 and 10 is not good either. They were bad for growth. They were bad for people getting a better life. It’s sometimes particularly harmful to low income people who can’t avoid it. They just lose because their savings get eroded away.

So, there’s many important reasons to have a lower inflation rate, you have to get it down. And there is some cost to getting it down in the short run. That’s the trade off. That’s why it’s so hard sometimes.

It was hard in the US. Every country that has tried to reduce the inflation rate has had these short-term costs. But eventually they’ve come through. It’s one of the reasons why you should think of central bank policy as not just this minute. It’s a longer term thing. Experience shows the goal of lower inflation is very valuable.

Also, I’d say with the right policy and the right expectations it can come down faster than you might think. And again, it used to be lots of debate. There was sort of a pessimistic view that you never could lower the inflation rate, it is always going to be high, and it is too costly to lower. But the policymakers who did it, found a great benefit from doing it. You could make it less costly. But, once it is very high, it’s like any kind of reform. If you have a policy that’s off, and you want to reform it, there’s a transition. And it’s sometimes costly, but it’s beneficial. You know, it’s like as a new regime: you have to start today and it’s going to be a different world, but the transition is always hard.

– So what you are saying is that once the inflation rate has been lowered down, then economic growth can be restored in a healthy way?

– Absolutely. And it can be very strong growth.

– When the economic crisis hit Ukraine, when the rate went up to 30%, the very big banking system cleanup occurred. So, the national bank closed many banks, small and big ones. We know that you researched the 2008 crisis in the US and you had some suggestions and statements about the Fed’s policy on whether or not to intervene (e.g. Lehman brothers, Bear Sterns and AIG). What is your view on the best and worst policies to rescue or clean up different banks and how it should be done?

– First of all, I would separate that question from the previous question about monetary policy. It’s a different question.

NBU wants to be sure that it doesn’t encourage risky behavior that leads to the problems in the banks in the first place.

You have to have good regulations on risk taking so banks don’t get to the situation where they have to be resolved. Then you want to fix the problem in the best way. So, sometimes that’s closing banks who are just not being run very well. And know that I speak just in the abstract because I don’t know the situation here.

So, banks that are insolvent or are not being managed well, have to be closed. Banks in which there’s some restoration of good lending would be the thing to do. What I mean by that is? If there’s a bank that has some short term funding problems, the central bank can provide loans to the institution as a lender of last resort.

And that can stabilize. But, the most important thing is to try to prevent it in the first place.

– As a result of this clean-up, we have a very low level of trust between Ukrainians and banks. How can we restore this trust?

– So, I’m not sure I know enough about the situation to comment on it.

Let me say this.

People get worried about their money, especially when there’re problems with financial institutions. People always say, they want to withdraw money. And sometimes it’s called bank runs.

The trust is important for that, and there’re different ways to get it.

One is the bank follows good financial rules. They can show that their balance sheet is safe. People get trust in the institution.

There’re also ways that the government has a role to insure the deposit against a run. We have deposit insurance in the United States. If a bank does collapse, people get some of their money back usually on small deposits.

But to get trust you have to verify. Verification can come either from the supervisors and the regulators in the bank. People who deposit their money into the bank have to have the ability to look at the bank’s books and make sure this is a safe proposition.

So, restoring and saving trust depends on a combination of things.

But again, I don’t know at all the situation here, so I can’t really comment on that. So, I’m speaking more generally. Banking crises are common. They happen in just about every single country, and your question about trust is very important.

– In the US, I remember, in 2008 the market just didn’t know what to do and where to move because the expectations were not set.

– Well, in the US, we had a problem in the crisis because the banks were heavily regulated by the Federal Reserve. For example, many supervisors and inspectors were on the bank’s premises – the New York banks – from the New York Federal Reserve’s branch of the Fed.

At the same time, big risks were being taken. There was a mix-up, a flaw in the regulatory system. That was the problem. For preventing it you have to have good people, you have to have strict enforcement of the risk-taking laws. I think there’s been some improvements in that since the crisis in the US.

Private sector, people who are depositing money in the banks, they’re also looking at the banks. So, sometimes they know much better about what’s good and what’s bad. In any situation, the private sector is inventing new techniques, new securities, new things to invest in. People in the private sector frequently know more about where the risks are than people in the government, so you have to have that there too.

– One more problem is high level of non-performing loans. Chairperson of the Verkhovna Rada of Ukraine Committee on Financial Policy and Banking Serhii Rybalka says that their level is 55%

Now government and NBU don’t have exact decisions of this problem. What are your recommendations?

– It’s always difficult to figure out how to deal with non-performing loans. We have had several episodes in United States, but that depends on the situation, depends on the traditions, and depends on who’s in charge.

– Take for example the government stepping in and rescuing and buying the really large bank with almost 90% of the portfolio in NPLs.

– Just think about my country. During the financial crisis, the financial firm named Bear Stearns was basically supported by a government bail out, and another financial firm – Lehman Brothers – wasn’t. And once more firm – AIG – was. So, there was quite a bit of mixture in policies. That’s probably not so good to have a mixture back and forth. But it shows you how difficult it is in practice.

– You are known your fiscal consolidation scenario for the US. According to this scenario the government gradually reduces spending over time in order to reduce the deficit and the growth of the debt. What is the best way of fiscal consolidation?

T: I like fiscal consolidation, and it’s got to be done – almost always gradually – but, it’s also good to do it. By fiscal consolidation, I mean a policy that gradually brings the deficit down and brings the growth of debt down. Consolidation means you’re getting rid of that deficit, fiscal deficit, budget deficit. We have a big deficit in the US.

So, we’ve got a find a way to consolidate, to slow the growth of spending. So, slowing the growth of spending will reduce the deficit. That’s an example of consolidation.

If you have a predictable or credible consolidation it is usually beneficial and it can be beneficial in the short run as well as the long run. Thus, the simulation of models and fiscal consolidation is a good thing to do. If you don’t do it, the debt will explode and you’re really in trouble down the road.

– What about Ukraine? We have a problem with the budget deficit and we have some plans of cutting expenses. But how can we do it without damaging the economic growth?

– First of all – do it gradually.

You know, if the spending has to come down, you don’t do it right now, you allow people get used to it.

And if you do it gradually then other good things will happen in the economy. Interest rates might come down lower because there’s less crowding out by the government. So, the interest rates will come down; that will stimulate the economy. It will influence people’s expectations, people will understand that spending is going down and they won’t have high taxes in the future, they’ll spend more. So there will be a benefit that way.

That’s why it’s important to be credible.

The problem is when the cutting is really fast. Then it is damaging because you surprise people, and they’re dependent on the spending or dependent on the transfers. They can’t adjust.

I think that – let’s just say it again – gradual and credible is important.

– And this was what happened with the countries who suffered from the fiscal austerity, like Greece, like Indonesia when the IMF stepped in years ago?

– Yes, frequently that’s the case. And in these cases hard not to do something sudden. But there is another reason – not to let things get so out of hand like in the case of Greece.

– We have discussion in the moment that whether the IMF policies are good or bad because of these fiscal austerity policies, and because of the examples like Tunisia, Malaysia, Indonesia, Greece and the other countries which suffered from this fiscal austerity. So, probably, the gradual way would be better to not to damage economic growth and at the same time to make this fiscal consolidation.

– Yeah. You know some IMF regulations are good, some are bad or not perfect, but I think the important thing is that if you need a consolidation, do it gradually and credibly. I hope the IMF would do it that way.

But, I think on top of all that if we are thinking about an overall program, there are other things to do that stimulates growth that do not increase the deficit.

– What are they?

– I would emphasize things that reduce the burden of regulations. The World Bank has the Doing Business indicators – and how long will it take to start up a business? That’s huge.

There’s ways that can get you economic growth without any cost for the budget. The other thing is if there’s tax reform. Tax reform to me is: you don’t lose revenues, but you lower the rate and expand the base. That can be very good for growth too, and that doesn’t increase the deficit.

IMF recommendations that include these cycled supply side or structural reforms are very important to go along with the fiscal changes.

The thing is almost none of them are easy politically. Right, there’s always some interest that doesn’t want a lot of change, but I think the regulatory side is important.

– So, also the other thing which is so widely discussed in Ukraine in terms of fiscal support of the economic growth. We have a very strong and historically rooted ill-known tradition of state supporting selected businesses. From time to time it’s just direct support, or the industry-wide plans, or preferences to some regions. But, on the other hand, probably, it could still create some good results for the economy. What do you think about this state support? Is it worth preserving certain types of direct or indirect types of state support of certain sectors of the economy?

– I don’t think these kinds of interventions are good for growth. Some of the economists like to say: if there’s something that you want to support – education, you have to have support the education.

But maybe that’s because I am a teacher and I like it. Some people argue that that research and development spreads a whole economy.

So, you need some support of that from government, but when you go through the list of a lot of things you say. Well, why should we be supporting textiles, there’s no real reason an extra, because anybody can make a shirt or blouse. So you shouldn’t have the government supporting that kind of industry.

And when you have government support to that kind of industry – it`s like a kind of stifle the private sector. You stifle innovation, and you stifle new technologies, so it can be bad for growth.

So, pulling that out is an important kind of reform. In this way you analyze when a subsidy is necessary. And even when it’s necessary you can think of the private sector helping.

In the US, many colleges and universities are private. So, you get funding from the government, but they are run by private institutions. You’re using the private sector to run it, but you’re still getting some support from the government. I would view it.

– We have a huge state support of higher education. Ukraine funds all the universities, and the number of universities per capita is higher than in Western Europe. The number of students entering the university in Ukraine is 80 percent of schoolchildren. Despite all this state support, the quality of higher education is poor. While primary education is under-financed.

– Well, I think it’s a problem not just for Ukraine. In the US there’s also a lot of support for our education, some of it is private. I mean like Stanford University is a private institution. Many-many donors supply money to Stanford – the government, a little bit – but it’s almost all private. Alumni firms are just giving money to Stanford. It’s well funded. But if you look at some of the schools, grade schools, kindergarten, first grade, third grade, fifth grade in the worst parts of those are cities, they are not good. They are very bad. In Southern California it’s quite bad in the center city, that’s same kind of problem that you’re talking about.

Let’s not forget about the kids. Especially the kids who are disadvantaged, and they need some support. In the US there’s a great move now to having more choice. If you live in a poor neighborhood, the idea of choices, you can go to another school if your family doesn’t like the school in your area. Children can go to a better school and maybe some of the competition will generate a better educational system.

There’s a lot of reforms that we can do in education.

I think that technology is going to help there. You have a way to do more things online, more and more competition will come. It is very important because technology is coming as you need people who are well equipped and well trained.

– In Ukraine, we don’t have any competition because they have just to lower their demands for the knowledge of people entering the university or they may set their contract fees ridiculously low, because the government will still fund the entity based on the quantity of students.

– I do know that if you have a way to give scholarships to people who don’t have any money, you can do it. It makes sense but people who have the money have to pay. That’s how it is at Stanford. If you have the money, you pay a lot of money for tuition and if you don’t have it, then you get a scholarship. So, I think that works well, otherwise, you end up subsidizing the rich people. That seems like a dumb idea.

– In autumn this year, Ukraine plans to return to foreign borrowing markets. In 2018, there is a need for intensification of external loans in view of large payments for debts in 2019th. Can you tell us about experience of the returning of the countries which were in the same situation as Ukraine now?

– Well, the analogies are not perfect but Mexico had huge trouble borrowing and it cut out a bit. They are now much better, they can borrow it’s really straightforward to borrow. There are a lot of examples, they are all different of course but the main thing is to get the reputation of paying the debt back, get to the reputation where this is a good investment.

You know the capital is a coward. There is always a fear to a loan to someone, who can’t pay back. Risk of sovereign default is very high and if there is a way that in borrowing you can restore that credibility and reduce some of the fear you could be in better shape. Many countries have done it in the past.

– And what about the first attitude of investors?

T: Investors do look to the future. More than you think. It’s like your question before about trust.

People will look up to the future and if you could change the attitude and change the credibility then the money will come and that will lower interest rates.

– Talking about credibility and future, probably before the last question. We had rather mixed policy on building Ukraine’s credibility to investors because Ukraine implemented very strict capital controls, you can’t pay dividends abroad, you can’t take out your investment. So, what can be done to regain trust?

– If you establish some credibility, if your leaders are talking about the importance of open capital markets and welcoming investment means you are not going to freeze it off. There’s various things, I think eventually it would be easier.

Flexible exchange rate should help with this problem.

There will be less need in capital controls because the exchange rate can a little bit adjust. I think the security questions will be hopefully less of a problem in the future so that will also help.

All those things come together.

So, the credible policies, credible monetary policy, credible fiscal policy and the statement make Ukraine open for business.

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